Tuesday, July 14, 2015

Regular readers will know that I am fond of trend following models that spot persistent macro trends, but stock indices have been rather choppy and range-bound for most of 2015. However, I believe that I have identified a couple of macro trends that are likely to be long lasting.

First, consider this three-year chart of the relative performance of US equities (SPY) against global stocks, as represented by the MSCI All-Country World Index (ACWI). US stocks have been in a relative uptrend against global stocks and that trend is continuing.

Second, I have been written much about China and its slowing economy. Investors should not get overly mesmerized over the wild gyrations of the Chinese stock market, as they are not representative of the economy. Instead, I have long advocated using more indirect means to gauge the health of their economy, such as the stock markets of China's major Asian trading partners. Recently, I wrote (see Back to our regular programming (of 2011), emphasis added):

Here is a chart of the "Greater China" markets, which consists of the stock markets of China's major Asian trading partners. Every single market is struggling with its 200 day moving average (dma), which is often used to delineates bull and bear markets, and, with the except of the Korean KOSPI, below its 200 dma. Investors have been overly focused on the gyrations of the Chinese stock market, which is divorced from the Chinese economy. If you want to really watch what is happening with Chinese growth, watch the "Greater China" markets - and they don't look healthy at all.

China is the largest marginal consumer of most commodities. If Chinese growth were to slow, then commodity prices are likely to suffer the most.

Putting the theme of global US equity leadership together with the idea of slowing Chinese growth, we can search for profit opportunities by buying sectors that are most exposed to the US economy and selling or shorting the sectors most exposed to the Chinese economy, namely commodities. In addition, the idea of commodity weakness also dovetails well with the news of the Iranian nuclear deal, in which additional Iranian crude is likely to flood an already oversupplied oil market this December.

Leaders and laggards

I therefore offer for your consideration, a few leading and lagging sectors. The charts below show the relative performance of US healthcare stocks (XLV), consumer discretionary stocks (XLY), energy stocks (XLE) and metal and mining stocks (XME) compared to the SPX. Sectors that are most sensitive to the US economy have been outperforming, while commodity sensitive sectors have lagged.

Four pair trades

This leads me to consider four pair trades, from the most timely to the least, at least for now. Here is Healthcare vs. Energy, which has been in a steady relative uptrend. The Relative Strength Indicator (RSI) is flashing as series of what my former Merrill Lynch colleague Walter Murphy used to call "good" overbought readings indicating an uptrend.

Here is the chart of Consumer Discretionary vs. Energy. This pair is also showing a solid relative uptrend and what appears to be the start of some "good" overbought readings.

The chart of Healthcare vs. Metals and Mining stocks appear a bit extended technically, largely because of the weakness of the Metals and Mining group.

The same could be said of the Consumer Discretionary vs. Metals and Mining pair trade.

Pairs trading is a relatively sophisticated strategy and it isn't for everyone, particularly for neophytes who are uncomfortable with short positions. As well, traders should understand some of the subtleties of risk control in pairs trading. However, these are some pair trades that represent some macro themes that are likely to be persistent into the future.

1 comment:

RAS
said...

Interesting post. Could you please provide more detail on risk management for pairs trades? I limit my position sizes and use trailing stops, but that's the extent of my "risk protection" measures, paltry as they may be. I'm sure there is more to it and I'd like to understand the details before attempting to implement a trade. If the discussion would be too time consuming, some links to sources you consider might be helpful would be appreciated.Thanks,RAS

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Welcome to my blog Humble Student of the Markets. These are my observations and musings about the markets (mostly equities), hedge funds and investments in general.My experience has been a quantitative equity manager in US, Canada, EAFE and Emerging Markets and commentator on hedge funds and their returns patterns.

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